From natural disasters, infrastructure damage, environmental explosions, cyber-attacks, pandemics, extreme weather or political and geopolitical conflicts, any action that creates turbulence, connectivity, sensitivity, or limits resources will introduce volatility and uncertainty into a supply chain.
This, in turn, affects the flexibility to support sales, leading to disruption, capacity changes, efficiency and reliability issues, reputational damage, and financial value impact, all of which businesses obviously want to protect against.
Conventional wisdom dictates that insurance policies are a promise of cash flow. They guarantee funds available in the event of a loss, which may have the potential to dent a balance sheet, interrupt business, damage reputation, or even distract or divert management goals. Yet policies are limited by cover, disclosure, material fact, condition precedent, legal interpretation, subjective analysis, and limit caps.
The general premise behind the majority of insurance products has remained essentially unchanged for over 300 years. Even new exposures like digitalisation, space, political activism and contamination follow the original model. Yet our interconnected world is widening beyond these risk parameters. One area of particular concern is supply chain security, as traditional insurance does not recognise its volatility and is, therefore, not a comprehensive option.
Businesses need to take a holistic approach to supply chain resilience. While insurance can provide some protection, the full spectrum of risk solutions is required in order to sustain product flow, market share, and income.
Product recall
The risk of product recall exists throughout the supply chain, not just with manufacturers. Distributors and wholesalers are also vulnerable to recall as they are liable for supplying contaminated or faulty products to retailers. Although they typically pass the costs back to the manufacturer, they have started to buy recall policies to cover these costs in case manufacturers refuse to pay or if their liability is capped under the terms of the contract. Recall insurance covers not only the recall and replacement costs but also first and third-party business interruption (BI), rehabilitation expenses, and third-party recall liability.
Recall claims can escalate quickly, and the costs associated with a recall can go into the millions due to transportation, advertising, communication, workforce maintenance, storage, and disposal. Reputational risk is also a factor, and a recall policy aims to cover all associated losses, including access to crisis consultants to advise on how to mitigate the size of the loss and manage communication with the media and consumers. With third-party recall liability coverage, the insured is legally liable for any damages claimed by third parties, including third-party business interruption, rehabilitation, and replacement costs.
Contract negotiation
Contract risk management is an excellent method of transferring risk from one party to another. However, negotiating contracts has become increasingly difficult. If the contract is negotiated well, the risk can be shifted away from a company, but if a supplier fails, a company may end up assuming risk. Even with effective contractual transfer, any dispute could result in years of litigation. Primary and contingent solutions are still required. As a risk consultant, Gallagher can advise on managing risk and insurance clauses and help clients understand the implications of complex clause triggers.
Business interruption
Business Interruption (BI) insurance can be expanded to cover various risks beyond just the standard forms of damage. Business owners should work with their brokers to analyse the scope of their coverage, including the extent of property damage proviso, the coverage limits and distances on extended premises or peril clauses, and the range of broader risks, such as debris removal, port damage, and property in transit. It is also essential to consider whether income protection is limited to owned property, in the business's own premises.
It is important to ask the right questions: Are limits maximised on heads of cover, and is every extended premise and risk clause utilised to its advantage? The cover can extend to additional working costs and alternative supply or production costs, and your broker should examine and raise the issue of average and inflation protection. A standard policy will seek to limit all of this. Consider also the limits and definitions for catastrophe – there is a reason they have been capped – they protect insurers. None of these are cheap options, and package deals will not offer cover extensions. If your business has supply exposure, you will need to discuss this with your broker.
Other insurance policies and associated products and services can also provide elements of BI protection depending on circumstance: stock throughput, credit, cyber, product recall, political risk, sabotage and terrorism, political violence, and the provision of delay in start-up for some industries are all examples. There is a misconception that only manufacturers shoulder some of this burden but consider recall as an example. Wholesalers and distributors are also exposed as they own the relationship and contract with the retailer. Recall policies cover first and third-party business interruption and provide additional support media and consumer support with crisis consultancy.
Any protection your broker can secure in a traditional interruption insurance policy is valuable, but it will only afford protection for first-tier suppliers. The complexity of outsourcing, cheaper economies, and their common exposure to more political instability and catastrophe events mean even a minor disruption in second-tier suppliers and beyond can also be hugely damaging to income and reputation.
Take a textbook example: a Philips US microchip factory had a fire in 2000. It was not a major one, but smoke and water damage destroyed the entire stock of microchips. Nokia and Ericsson were hugely affected. It cost Ericsson USD400 million at the time. Twenty-four years later, with inflation, increased production costs, and the added cyber revolution, this will seem like a drop in the ocean. Philips recovered via a traditional own-damage business interruption claim. Nokia had identified and secured spare capacity. It also planned a re-engineer of phones to take alternative supplier chips. Ericsson had a single source supplier and left the mobile phone business1.
Supply chain cover
A very limited insurance market is available for the entire supply chain exposure. However, for this insurance to work, a complete mapping of the chain and a demonstration of the application of mitigation techniques are required. This exercise can be considered a business risk; therefore, the full spectrum of risk management and business continuity should be employed to protect it. Traditional financial compensation will be offered on the residual risk in cases of insured damage or loss of part of a supply chain, making it fortuitously insurable.
In wider, more niche products, the cover will extend to broader chains of events such as strikes, political instability, industrial accidents, and infrastructure disruption. These are difficult to secure, and, as noted above, by the time the mapping is done, the insurance may not be needed or possible. However, this very much depends on the supply chain itself. Once the residual exposure is identified, the coverage becomes more parametric in design than traditional proximate loss. This pot of money could be the difference between Nokia and Ericsson and enable the protection of income as well as brand and reputation.
Parametric insurance
After assessing the resiliency of contingency planning throughout a supply chain and exhausting traditional policy options, one potential source of residual financial exposure is a parametric insurance product. Put simply, parametric solutions are an alternative risk finance product that pays a predetermined amount based on the occurrence of a specific event. They do not require a detailed assessment of actual loss or damage but use pre-defined parameters or triggers to determine loss payout.
Parametric insurance is not an attritional risk product and is not a replacement for traditional insurance. It fills the gap left by indemnity insurance from deductibles, excluded perils, events, and remote or contingent loss. It is a complementary solution for purely financial losses or uninsurable perils. Parametric insurance is more direct in its approach to loss triggers and responds well to supply disruption.
A payment can be made once an event happens, and the specific parametric index (definition of event) is triggered. The trigger is probability-based; payment is not indemnity-based. The trigger remains fortuitous and of financial relevance to the policyholder. Modelling is complex and potentially commercially intrusive, but the product is of great value for the non-mitigated residual risk. It can provide coverage for risks that may be difficult to insure traditionally, such as crop yield fluctuations, revenue loss due to adverse weather conditions or single source supply.
Parametric products rely on data, and the prevalence of data for all sorts of events, scenarios, and mitigations is growing daily, which means the products will become increasingly relevant in risk transfer strategies. As there is no need for adjustment, parametric insurance offers faster claims settlement and reduced administrative costs.
A solution like this requires a different attitude to risk and stakeholder buy-in, but combined with risk management, mitigation, and traditional insurance strategies, it will provide resilience and the funds to withstand turbulence and protect income and brand.
Conclusion
Businesses need to adopt a holistic approach to protect their supply chain from various risks and challenges that can impact it. While insurance policies can provide some protection, they are limited by cover, disclosure, and legal interpretation. To build a more resilient supply chain, businesses should also consider other solutions such as business continuity strategies, product recall policies, and effective contract negotiation. By working with their broker and taking a holistic approach to supply chain management, businesses can protect themselves against the risks and challenges of today's marketplace.
